Options Fuel Acquisition Frenzy

The economy is open to convenience retailers intent on upgrading their operations. Learn what you need to know about debt financing and sales leasebacks in the current real estate environment.

By Mark Radosevich

The ongoing waves of petroleum industry consolidation and acquisitions have been the news of late, but not much has been reported about the corresponding financing environment that has been its catalyst.

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In preparing this article, I discussed the subject with various well-known petro-lenders and sale leaseback investors to gain a better understanding of the business today and help bring some clarity as to various borrower preferences and motivations, based upon two primary operational models.

Prior to diving into the subject, it’s worth noting a few quiet elephants in the room: the growing national debt, budget deficits and resultant higher interest rates. Our national debt obligation currently equates to $65,000 per person or $175,000 per taxpayer.

The key takeaway is the uncertainty as to where interest rates are headed and how that will affect existing mortgages with periodic rate adjustments, new mortgages and sale/leaseback rent capitalization rates. Higher interest rates will negatively influence acquisition multiples, as cash flows must cover higher payments and rents. But, let’s focus on the here and now, while financing options are plentiful, interest rates and lease cap rates are low and quality c-stores still trade at high valuation levels.

The store acquisition end game for traditional marketer-buyers is to grow equity for future generations of the business, using debt financing and the gradual extinguishing of mortgages to yield ingrained equity. On the flip side, as mortgages are paid down, depreciation and interest tax deductions are also diminished and depreciation recapture becomes a reality when the properties are eventually sold.

This deliberate slow grow strategy is exactly what industry lending institutions are looking for. They strive to form long-term relationships with established quality operators, running quality stores for the funding and facilitation of growth and operational upgrades.

In today’s highly acquisitive market, a debt financing approach has shut out many traditional marketers from choice acquisition opportunities, as high purchase multiples have stretched beyond traditional lender limitations. This requires higher levels of buyer equity investments or more creative financing structures that few marketers are willing to embrace. To grow in this environment, marketers are relegated to finding quiet deals that fly below the radar.

For store operators, income is the end game. Having equity tied up in real estate is a drag on operational growth and limits income potential. These operators tend to be equity groups or investors that use sale leaseback financing to make acquisitions with reduced investments of their own cash. The higher advance rates that sale leaseback provides is a key contributor to the run-up in purchase multiples and acquisition prices.

Leasing allows full tax deductibility of rent payments through the life of the lease versus property ownership where interest and depreciation tax write-offs diminish through time. Most institutional leases contain various covenants designed to protect the investor/landlord including assignment clauses that limit the lessee-operator’s ability to exit a site by transferring the lease to another operator without the landlord’s consent. Lease transfer consent usually requires the assigned-party to have a credit rating equal or better than the current lessee-operator.

All told, lease transfers work well when the lessee-operator is able to improve store profitability and resultant enterprise value and then flip the lease to a larger entity while pocketing upside proceeds.

Conversely, when a once profitable site becomes significantly impaired due to new competition or other reasons, a substitution clause helps mitigate the downside by allowing the lessee to exit the site by substituting another property in its place.

Lease rates are based upon a number of criteria including the strength of the operator, geographic area of operation and location of the subject properties, with urban or suburban being preferred over rural sites. The investors ultimately assess the value of the underlying real estate in case they have to take the store back in the future.

Concentration is another risk analysis factor, whereby investors assess the current number of leases that they already have in a given market or with an individual lessee-operator and try to avoid having too much concentration in either area.

Preservation of equity is a primary exit consideration for traditional petroleum marketers. Through time, reduced debt and fully depreciated stores leaves many with a significant amount of capital gains and depreciation recapture that will significantly erode proceeds from a sale.

Tax and estate planning must go hand-in-hand with strategic business planning to help avoid last minute scrambling once the business is marketed and an acceptable purchase offer is obtained. Few things are more disconcerting than to inform a willing and able buyer that you can’t ultimately accept a previously acceptable offer because some last minute tax related considerations arose.

One tax mitigation approach is to sell the business enterprise and enter into a marketable lease on the stores with the buyer. Depending upon the financial strength of the buyer, the lease may be sold sometime in the future to another investor and the proceeds retained as cash or substituted for another non-petroleum related lease using the IRS 1031 provision. This capital gains deferment method allows one property to be exchanged for another like kind property. Leasing the stores preserves equity and provides consistent rental income from that equity.

One downside of this exit strategy is that a leasing provision will limit the number of qualified buyers that will assess the deal. For highly profitable stores of a modern configuration, the chances are great that a significant number of pro-leasing pure store operators (as discussed above) will participate in the sale.

Better tenant quality will improve the value of the lease while enhancing the chances to sell the lease to a third party investor. Many marketers reject the idea of taking back a lease and prefer to pay the tax; for fear that they may someday be forced to take back an impaired store after they’ve fully exited from the industry. The following example may dispel those fears:

Leasing of the Subject Store:
(EBITDAR = Earnings before Interest Taxes Depreciation Amortization and Related Entity Rent)
1. EBITDAR is $100,000, buyer pays 3.5 times for the Business Enterprise = $350,000 cash at closing.
2. Buyer enters into a lease for 50% of EBITDAR, Annual Rent = $50,000 per year or $4,167 per month.
3. In seven years the lessee-operator will have paid back an amount equal to the Enterprise Value ($350,000) yielding total proceeds of $700,000 or a seven times multiple of EBITDA (an amount the store would have sold for in the beginning), and the marketer still owns the store.
4. Should the marketer garner a quality tenant, the lease may be sold to an investor at an attractive rent capitalization rate. Using a cap rate of 8%, the lease with $50,000 in annual rent is now worth over $625,000. When added to the initial business enterprise proceeds, the overall store value increases to $975,000 versus $700,000 if it was initially sold for a seven multiple of EBITDAR. When considering the tax savings, rental income and potential upside, a fear of someday getting the stores back seems unwarranted.

In summary, given the current and continuing low interest rate environment, there is a lot of capital out there looking for a place to park. The window of opportunity for high valuation multiples, fueled by multitudes of willing buyers and their lenders, will begin to close as interest rates rise. Marketers that are contemplating an exit should pragmatically consider taking a sooner-than-later approach, while buyer and lender appetite is high, rent capitalization rates are low and before traditional valuation levels return.